Protecting Against Common Pitfalls Encountered By Landlords in Bankruptcy Cases

The Bankruptcy Code was amended in 1984 to address several shortcomings that adversely affected landlords. For example, prior to 1984, debtors and trustees were not required to pay rent immediately during the period between the filing of a bankruptcy petition and the date of the assumption or rejection of a nonresidential lease. In re New Almacs, Inc., 196 B.R. 244, 247 (Bankr. N.D.N.Y. 1996). That is, a tenant could occupy a landlord's premises while a landlord did not have recourse to compel the immediate payment of rent. Consequently, landlords became “involuntary creditors” who, unlike the post-petition trade creditors of a Chapter 11 debtor, did not voluntarily bear the risks of dealing with a Chapter 11 debtor, but were nevertheless forced to supply current services without current payment. See 130 Cong. Rec. S8, 994-95 (daily ed. June 29, 1984) (statement of Sen. Hatch).

To remedy this type of problem, section 365(d)(3) of the Bankruptcy Code was amended to require debtors to “timely perform” their obligations under the lease until the lease is either assumed or rejected. Some courts have in fact adopted a bright-line rule that all claims arising from a debtor's nonperformance of post-petition, pre-rejection lease obligations are entitled to administrative expense priority. Cukierman v. Uecker (In re Cukierman), 265 F.3d 846, 849 (9th Cir. 2001). Therefore, in the typical bankruptcy case, landlords should be paid post-petition rent on a timely basis.

However, when a debtor has accrued greater post-petition liabilities than it has assets (ie, the debtor is administratively insolvent), the Bankruptcy Code does not provide a remedy for timely payment, and there is a substantial risk that a landlord may not be paid in full. The minority of courts that have decided this issue hold that a landlord is entitled to pre-rejection rent on a superpriority basis, even if the estate is administratively insolvent. The majority holds that there is no express language in the Bankruptcy Code that grants the landlord a superpriority and that a landlord must share ratably with other administrative creditors. The rationale for the majority position is that neither '365 nor '503(b) of the Bankruptcy Code govern such priorities and neither section was intended to grant a landlord priority over other administrative claimants. Thus, a landlord is not entitled to a superpriority, but is entitled to immediate payment of pre-rejection rent only if it is shown that the estate is administratively solvent.

Because there is still a risk of nonpayment during a bankruptcy case, a landlord must closely monitor the case. When a landlord is not paid its rent on a timely basis, the landlord, as an administrative claimant, is not without a remedy. Specifically, the landlord may: 1) file a motion seeking an order to compel the debtor to pay pre-rejection rent immediately; 2) move for an order requiring the debtor to surrender the premises; 3) file a motion for relief from the stay and evict the debtor; or 4) move for an order to convert the case to Chapter 7. See In re J.T. Rapps, Inc., 225 B.R. 257, 263 (Bankr. D. Mass. 1998). If the landlord does not monitor the case and does not receive timely rental payments, there is a substantial chance that the landlord will not be paid in full by the administratively insolvent debtor. In addition, if there is a breach of the lease during the pendency of the bankruptcy case, the landlord should seek to have all attorneys' fees paid by the debtor as a result of such breach; however, there must be a provision in the landlord's lease that provides, upon a breach, payment of attorneys' fees on demand as the fees are incurred. See In re Exchange Resources, Inc., 214 B.R. 366, 369-70 (Bankr. D. Minn. 1997); In re Pacific Sea Farms, Inc., 134 B.R. 11, 15-16 (Bankr. D. Haw. 1991); In re Revco D.S., Inc., 109 B.R. 264, 273 (Bankr. N.D. Ohio 1989).

Cure Notices

The Bankruptcy Code allows a debtor to assume a lease, assume and assign the lease to a third party, or reject a lease. If the debtor seeks to assume, or assume and assign, a lease, the Bankruptcy Code, 11 U.S.C. '365, imposes certain restrictions on those actions:

1) If a lease is in default at the time of the assumption, the debtor must promptly cure the default or provide adequate assurance the default will be promptly cured;

2) The debtor must compensate or provide for prompt compensation for the actual pecuniary loss resulting from the default; and

3) The debtor must provide adequate assurance of future performance under the lease.

In connection with a proposed assumption or assumption and assignment, a debtor must provide notice to the affected landlord of the proposed treatment of the lease. If the debtor seeks to assume or assume and assign, the debtor must advise the landlord of: 1) the amounts which will be paid to cure defaults; 2) the timing of the payments or compensation to cure the defaults; and 3) if there is a proposed assignment, the assignee and the financial condition of the assignee. The notice may be a separate pleading or the notice could be embodied in a plan of reorganization.

Upon receiving the notice, the landlord is provided an opportunity to contest the amount of the cure, the timing of the cure and the proposed adequate assurance of future performance. If the landlord timely contests the proposed assumption or assumption and assignment, the bankruptcy court will conduct a hearing or trial to determine the merits of the claim.

However, if the landlord fails to respond to the proposed cure notice, the landlord could face grave consequences. When a bankruptcy court approves the assumption of an executory contract, it necessarily makes a finding that no uncured defaults exist. In Re Lykes Bros. Steamship Co., 221 B.R. 881, 883 (Bankr. M.D. Fla. 1997) (“If prior to the assumption of any executory contract there is no allegation of any existing default, the order approving the contract determines that no default exists.”); In re Diamond Mfg. Co., 164 B.R. 189, 197 (Bankr. S.D. Ga. 1994); NCL Corn v. Lone Star Bldg. Centers (Eastern), Inc., 144 B.R. 170, 179 (S.D. Fla. 1992). Thus, “[t]he nonbankrupt party [to an executory contract] bears [the] burden to assert any defaults prior to the assumption.” In re Diamond Mfg. Co., 164 B.R. at 199. Where the landlord has knowledge of facts sufficient to place the party on notice that a “potential” pre-confirmation breach has occurred, res judicata bars that party from later asserting a claim based upon the pre-petition breach. Id. at 201.

Therefore, if a landlord was aware, or reasonably should have been aware, of a breach of its lease, the landlord must advise the bankruptcy court of the breach in connection with the assumption process. For example, assume prior to the commencement of the bankruptcy case, a debtor tenant was required to update a sprinkler system pursuant to the terms of the lease, but failed to do so. Subsequently, the debtor seeks to assume the lease during the bankruptcy case. If the debtor sends the landlord a notice stating that there are no defaults under the lease, and if the landlord does not object to the proposed assumption, the landlord has effectively waived the default relating to the sprinkler system. Therefore, the landlord must advise the court of all monetary and nonmonetary defaults and/or breaches. If a landlord does not object to a proposed assumption or assumption and assignment, the landlord will be bound by the transaction. Any of the landlord's claims for pre-assumption defaults are barred by the doctrine of res judicata. See NCL Corp. v. Lone Star Bldg. Centers (Eastern) Inc., 144 B.R. 170, (S.D. Fla. 1992); see also In re USN Communications, Inc., 280 B.R. 573, 586 (Bankr. D. Del. 2002) (“The doctrine of res judicata (or claim preclusion) precludes a party from re-litigating claims that were or could have been asserted in a prior action.”); In re Mariner Post-Acute Network, Inc., 267 B.R. 46, 52 (Bankr. D. Del. 2001); CoreStates Bank. N.A. v. Hulls America, Inc., 176 F.3d 187, 194 (3d Cir. 1999). Landlords should treat cure notices similar to notices that establish bar dates for the filing of claims by strictly complying with the terms of the notice and order.

The Ride-Through Doctrine

As stated above, during a bankruptcy case a debtor has the choice of either assuming a lease, assuming and assigning a lease, or rejecting a lease. However, there are instances when the debtor takes none of these actions. When the debtor does not take any of these actions, and the debtor has yet to confirm a plan, the landlord should object to the plan and require that the debtor either assume, assume and assign, or reject the lease. Assuming that a debtor files a plan that is silent regarding the treatment of the landlord's lease, the parties are put into a quagmire because the debtor did not take a required action and the landlord failed to object to the debtor's plan. Because this confluence of events occurs all too frequently, bankruptcy courts have established the “ride-through” doctrine.

The “ride-through” doctrine provides that leases that are neither affirmatively assumed nor rejected by the debtor pass through the bankruptcy unaffected. See eg, In re Polysat, Inc., 152 B.R. 886, 890 (Bankr. E.D. Pa. 1993) (“In a Chapter 11 case, where a debtor has failed to expressly assume or reject a[n] … executory contract, that … contract will be unaffected by the bankruptcy filing”); In re Day, 208 B.R. 358, 368 (Bankr. E.D. Pa. 1997) (holding that “[i]t has long been the rule in bankruptcy that an executory contract that is neither assumed nor rejected continues in place between the parties, passing through the bankruptcy to the reorganized debtor”). The ride-through doctrine is simply the traditional manner in which the courts deal with executory contracts or leases that for some reason were not assumed or rejected prior to or at confirmation.

Ride-through has also been recognized by the U.S. Supreme Court in dicta. In his concurring and dissenting opinion in National Labor Relations Board v. Bildisco, 465 U.S. 513, 546 n. 12, 104 S.Ct. 1188, 79 L.Ed.2d 482 (1984), Justice William J. Brennan, Jr. wrote:

In the unlikely event that the contract is neither accepted nor rejected, it will 'ride through' the bankruptcy proceeding and be binding on the debtor even after a discharge is granted. The nondebtor party's claim will therefore survive the bankruptcy proceeding.

If the landlord is placed in a position where there is a lease that is subject to the ride through doctrine, the landlord should treat the tenant as if the bankruptcy did not occur. If there are any defaults, the landlord should try to enforce the defaults. The landlord may face an argument by the debtor tenant that the lease should not be affected when the lease is subject to the ride through doctrine.

Conclusion

Similar to other specialized areas of the law, bankruptcy has all too many traps for unwary, but sophisticated, participants. If a landlord is forced to confront a debtor tenant, the landlord should be aware of its rights and the many pitfalls that it can face and should be proactive by monitoring the case and asserting all rights. Moreover, since bankruptcy laws quickly evolve and bankruptcy courts often utilize their powers to foster reorganizations at the expense of creditors, landlords cannot always rely on their traditional approach to bankruptcy cases. Each bankruptcy case is unique, and landlords must be aware of the new trends that adversely affect a landlord's rights. Vigilance by a creditor often pays a dividend in a bankruptcy case.

Since its enactment in 1978, the Bankruptcy Code has provided a means for debtors either to reorganize their financial affairs or to liquidate their assets. Within this framework, bankrupt tenants have often utilized the provisions of the Bankruptcy Code to the detriment of landlords, and landlords have increasingly become either involuntary creditors or financiers during a bankruptcy case or have suffered some type of unexpected loss.

Landlords have also been impacted because bankruptcy courts have developed case law to protect tenants under the auspices of creating value for all creditors. Against this backdrop, it is important for a landlord to be aware of some of the common pitfalls that it can face in a bankruptcy case so that it can protect its rights in a proactive manner. A vigilant landlord that is aware of the usual traps can be successful in minimizing its exposure and maximizing the value of its claim. This article discusses some of the pitfalls that landlords encounter when faced with issues relating to the treatment of leases in bankruptcy cases.

Timely Payment of Rent

The Bankruptcy Code was amended in 1984 to address several shortcomings that adversely affected landlords. For example, prior to 1984, debtors and trustees were not required to pay rent immediately during the period between the filing of a bankruptcy petition and the date of the assumption or rejection of a nonresidential lease. In re New Almacs, Inc., 196 B.R. 244, 247 (Bankr. N.D.N.Y. 1996). That is, a tenant could occupy a landlord's premises while a landlord did not have recourse to compel the immediate payment of rent. Consequently, landlords became “involuntary creditors” who, unlike the post-petition trade creditors of a Chapter 11 debtor, did not voluntarily bear the risks of dealing with a Chapter 11 debtor, but were nevertheless forced to supply current services without current payment. See 130 Cong. Rec. S8, 994-95 (daily ed. June 29, 1984) (statement of Sen. Hatch).

To remedy this type of problem, section 365(d)(3) of the Bankruptcy Code was amended to require debtors to “timely perform” their obligations under the lease until the lease is either assumed or rejected. Some courts have in fact adopted a bright-line rule that all claims arising from a debtor's nonperformance of post-petition, pre-rejection lease obligations are entitled to administrative expense priority. Cukierman v. Uecker (In re Cukierman), 265 F.3d 846, 849 (9th Cir. 2001). Therefore, in the typical bankruptcy case, landlords should be paid post-petition rent on a timely basis.

However, when a debtor has accrued greater post-petition liabilities than it has assets (ie, the debtor is administratively insolvent), the Bankruptcy Code does not provide a remedy for timely payment, and there is a substantial risk that a landlord may not be paid in full. The minority of courts that have decided this issue hold that a landlord is entitled to pre-rejection rent on a superpriority basis, even if the estate is administratively insolvent. The majority holds that there is no express language in the Bankruptcy Code that grants the landlord a superpriority and that a landlord must share ratably with other administrative creditors. The rationale for the majority position is that neither '365 nor '503(b) of the Bankruptcy Code govern such priorities and neither section was intended to grant a landlord priority over other administrative claimants. Thus, a landlord is not entitled to a superpriority, but is entitled to immediate payment of pre-rejection rent only if it is shown that the estate is administratively solvent.

Because there is still a risk of nonpayment during a bankruptcy case, a landlord must closely monitor the case. When a landlord is not paid its rent on a timely basis, the landlord, as an administrative claimant, is not without a remedy. Specifically, the landlord may: 1) file a motion seeking an order to compel the debtor to pay pre-rejection rent immediately; 2) move for an order requiring the debtor to surrender the premises; 3) file a motion for relief from the stay and evict the debtor; or 4) move for an order to convert the case to Chapter 7. See In re J.T. Rapps, Inc., 225 B.R. 257, 263 (Bankr. D. Mass. 1998). If the landlord does not monitor the case and does not receive timely rental payments, there is a substantial chance that the landlord will not be paid in full by the administratively insolvent debtor. In addition, if there is a breach of the lease during the pendency of the bankruptcy case, the landlord should seek to have all attorneys' fees paid by the debtor as a result of such breach; however, there must be a provision in the landlord's lease that provides, upon a breach, payment of attorneys' fees on demand as the fees are incurred. See In re Exchange Resources, Inc., 214 B.R. 366, 369-70 (Bankr. D. Minn. 1997); In re Pacific Sea Farms, Inc., 134 B.R. 11, 15-16 (Bankr. D. Haw. 1991); In re Revco D.S., Inc., 109 B.R. 264, 273 (Bankr. N.D. Ohio 1989).

Cure Notices

The Bankruptcy Code allows a debtor to assume a lease, assume and assign the lease to a third party, or reject a lease. If the debtor seeks to assume, or assume and assign, a lease, the Bankruptcy Code, 11 U.S.C. '365, imposes certain restrictions on those actions:

1) If a lease is in default at the time of the assumption, the debtor must promptly cure the default or provide adequate assurance the default will be promptly cured;

2) The debtor must compensate or provide for prompt compensation for the actual pecuniary loss resulting from the default; and

3) The debtor must provide adequate assurance of future performance under the lease.

In connection with a proposed assumption or assumption and assignment, a debtor must provide notice to the affected landlord of the proposed treatment of the lease. If the debtor seeks to assume or assume and assign, the debtor must advise the landlord of: 1) the amounts which will be paid to cure defaults; 2) the timing of the payments or compensation to cure the defaults; and 3) if there is a proposed assignment, the assignee and the financial condition of the assignee. The notice may be a separate pleading or the notice could be embodied in a plan of reorganization.

Upon receiving the notice, the landlord is provided an opportunity to contest the amount of the cure, the timing of the cure and the proposed adequate assurance of future performance. If the landlord timely contests the proposed assumption or assumption and assignment, the bankruptcy court will conduct a hearing or trial to determine the merits of the claim.

However, if the landlord fails to respond to the proposed cure notice, the landlord could face grave consequences. When a bankruptcy court approves the assumption of an executory contract, it necessarily makes a finding that no uncured defaults exist. In Re Lykes Bros. Steamship Co., 221 B.R. 881, 883 (Bankr. M.D. Fla. 1997) (“If prior to the assumption of any executory contract there is no allegation of any existing default, the order approving the contract determines that no default exists.”); In re Diamond Mfg. Co., 164 B.R. 189, 197 (Bankr. S.D. Ga. 1994); NCL Corn v. Lone Star Bldg. Centers (Eastern), Inc., 144 B.R. 170, 179 (S.D. Fla. 1992). Thus, “[t]he nonbankrupt party [to an executory contract] bears [the] burden to assert any defaults prior to the assumption.” In re Diamond Mfg. Co., 164 B.R. at 199. Where the landlord has knowledge of facts sufficient to place the party on notice that a “potential” pre-confirmation breach has occurred, res judicata bars that party from later asserting a claim based upon the pre-petition breach. Id. at 201.

Therefore, if a landlord was aware, or reasonably should have been aware, of a breach of its lease, the landlord must advise the bankruptcy court of the breach in connection with the assumption process. For example, assume prior to the commencement of the bankruptcy case, a debtor tenant was required to update a sprinkler system pursuant to the terms of the lease, but failed to do so. Subsequently, the debtor seeks to assume the lease during the bankruptcy case. If the debtor sends the landlord a notice stating that there are no defaults under the lease, and if the landlord does not object to the proposed assumption, the landlord has effectively waived the default relating to the sprinkler system. Therefore, the landlord must advise the court of all monetary and nonmonetary defaults and/or breaches. If a landlord does not object to a proposed assumption or assumption and assignment, the landlord will be bound by the transaction. Any of the landlord's claims for pre-assumption defaults are barred by the doctrine of res judicata. See NCL Corp. v. Lone Star Bldg. Centers (Eastern) Inc., 144 B.R. 170, (S.D. Fla. 1992); see also In re USN Communications, Inc., 280 B.R. 573, 586 (Bankr. D. Del. 2002) (“The doctrine of res judicata (or claim preclusion) precludes a party from re-litigating claims that were or could have been asserted in a prior action.”); In re Mariner Post-Acute Network, Inc., 267 B.R. 46, 52 (Bankr. D. Del. 2001); CoreStates Bank. N.A. v. Hulls America, Inc., 176 F.3d 187, 194 (3d Cir. 1999). Landlords should treat cure notices similar to notices that establish bar dates for the filing of claims by strictly complying with the terms of the notice and order.

The Ride-Through Doctrine

As stated above, during a bankruptcy case a debtor has the choice of either assuming a lease, assuming and assigning a lease, or rejecting a lease. However, there are instances when the debtor takes none of these actions. When the debtor does not take any of these actions, and the debtor has yet to confirm a plan, the landlord should object to the plan and require that the debtor either assume, assume and assign, or reject the lease. Assuming that a debtor files a plan that is silent regarding the treatment of the landlord's lease, the parties are put into a quagmire because the debtor did not take a required action and the landlord failed to object to the debtor's plan. Because this confluence of events occurs all too frequently, bankruptcy courts have established the “ride-through” doctrine.

The “ride-through” doctrine provides that leases that are neither affirmatively assumed nor rejected by the debtor pass through the bankruptcy unaffected. See eg, In re Polysat, Inc., 152 B.R. 886, 890 (Bankr. E.D. Pa. 1993) (“In a Chapter 11 case, where a debtor has failed to expressly assume or reject a[n] … executory contract, that … contract will be unaffected by the bankruptcy filing”); In re Day, 208 B.R. 358, 368 (Bankr. E.D. Pa. 1997) (holding that “[i]t has long been the rule in bankruptcy that an executory contract that is neither assumed nor rejected continues in place between the parties, passing through the bankruptcy to the reorganized debtor”). The ride-through doctrine is simply the traditional manner in which the courts deal with executory contracts or leases that for some reason were not assumed or rejected prior to or at confirmation.

Ride-through has also been recognized by the U.S. Supreme Court in dicta. In his concurring and dissenting opinion in National Labor Relations Board v. Bildisco, 465 U.S. 513, 546 n. 12, 104 S.Ct. 1188, 79 L.Ed.2d 482 (1984), Justice William J. Brennan, Jr. wrote:

In the unlikely event that the contract is neither accepted nor rejected, it will 'ride through' the bankruptcy proceeding and be binding on the debtor even after a discharge is granted. The nondebtor party's claim will therefore survive the bankruptcy proceeding.

If the landlord is placed in a position where there is a lease that is subject to the ride through doctrine, the landlord should treat the tenant as if the bankruptcy did not occur. If there are any defaults, the landlord should try to enforce the defaults. The landlord may face an argument by the debtor tenant that the lease should not be affected when the lease is subject to the ride through doctrine.

Conclusion

Similar to other specialized areas of the law, bankruptcy has all too many traps for unwary, but sophisticated, participants. If a landlord is forced to confront a debtor tenant, the landlord should be aware of its rights and the many pitfalls that it can face and should be proactive by monitoring the case and asserting all rights. Moreover, since bankruptcy laws quickly evolve and bankruptcy courts often utilize their powers to foster reorganizations at the expense of creditors, landlords cannot always rely on their traditional approach to bankruptcy cases. Each bankruptcy case is unique, and landlords must be aware of the new trends that adversely affect a landlord's rights. Vigilance by a creditor often pays a dividend in a bankruptcy case.